Once again, Tom Vanderwell here with some thoughts about moral hazard….
Barry Ritholz at The Big Picture
had these two comics that brought to the forefront again the issue of
moral hazard. Check out the comics and then we’ll talk “on the other
side.”
Okay, now some thoughts about moral hazard:
The definition of moral hazard (as taken from that scholarly journal, Wikipedia):
Moral hazard is the prospect that a party insulated from
risk may behave differently from the way it would behave if it were
fully exposed to the risk. Moral hazard arises because an individual or
institution does not bear the full consequences of its actions, and
therefore has a tendency to act less carefully than it otherwise would,
leaving another party to bear some responsibility for the consequences
of those actions.
Let’s break that down and look at it a little more closely in light of the current market environment:
a party insulated from risk may behave differently…. What
that means is that, frankly, the people on Wall Street and the bankers
on Main St. (including yours truly) might very well have done things
differently over the last few years if we had been more fully exposed
to the risk. Will Fannie or Freddie buy it? That’s all that most
mortgage lenders really cared about when structuring a loan. On Wall
Street, the guys (I’m using that term in a gender neutral sense, okay?)
who packaged these loans up and sold them as securities didn’t really
care how they performed, all they cared about was the great big fat
commissions that they made. The rating agencies didn’t care about
whether they really told the truth about these mortgage backed
securities, all they cared about was getting the big fat commission
checks.
And so what do we have now? We have, between Wachovia and
Washington Mutual, $10.1 billion in loan loss provisions in the last 12
hours. That’s for a period of 90 days folks. I was going to figure
out the cost per day but my calculator doesn’t crunch numbers that big!
Moral hazard arises because an individual or institution does not bear the full consequences of its actions.
But how can we prevent a total meltdown of the housing and mortgage market (what would happen if Fannie and Freddie actually went under) without absolving some of the participants
(for this particular discussion, we’ll limit it to Wall St., the
Ratings Agencies, the Mortgage Companies, and the Banks who wrote the
loans oh, and the mortgage lenders themselves if they did anything
criminal or fraudlent) of at least some of their consequences?
Let me offer a few suggestions to start the discussion:
1. If the US Government has to step in to bail out any more
financial institutions (aka Bear Stearns Take 2), the shareholders
should get virtually no value for their existing shares. Years ago, I
bought stock in AutoDie (a local die manufacturing company). It went
bankrupt, I lost all $1000 that I put into it. (I know, big time
investment). I know what you’re thinking – what about the FDIC and
banks that fail? I’m not proposing a change in the way of FDIC,
that’s going to continue to work the way it works and I’m all for
that. I’m talking about the Bear Stearns, Lehman Brothers, Goldman
Sachs type of investment banks.
2. If the US Government has to step in to bail out Fannie and
Freddie, I think the only way that should be done would be for a couple
of things to happen: 1) Existing shares should be turned into some
sort of subordinated debt where the only way the shareholders would get
any of their investment back is once Fannie and Freddie are paid back
and they are turning a profit and then they would get back a nominal
“dividend” until 5 years of profitability has happened. 2) The
existing management along with their exorbitant compensation structure
need to be shown the door (I could ruin Freddie Mac for a lot less than
$20 million per year!) 3. There needs to be a 10 year plan put in
place to eventually move Fannie and Freddie from GSE’s (Government
sponsored entities) to totally private enterprises. It needs to be
done but the market is too fragile to handle it now. That’s why I’m
proposing a 10 year plan.
I know that there are companies who indeed are too big to fail, the
economic devastation that would be caused by them failing would be
significantly worse than stepping in to save them. But I’m getting
the very uneasy feeling that the rally in the financial stocks that we’ve seen going on in the last week is being caused/encouraged/related to some sort of an “It’s
going to be okay, because Uncle Sam is going to bail out Fannie and
Freddie and that will save us from all of our bad investments and the
world will be okay.
The world is not without risk, a lot of risk, but when there isn’t
the consequences as well as the rewards for the risk, something has
gone wrong. According to reports that I’ve read, this bailout could
cost all of us $25 billion.
We better make sure we do it right or we’ll all be paying for it for it
for a long time and we better make sure things are set up so that the
same risk without consequence issue doesn’t come back to haunt us again.
What do you think we should do?
Tom Vanderwell
If you like what I’m writing, check out more of my thoughts and action plans about the mortgage industry at www.straighttalkaboutmortgages.com.
Related posts: